3/11/2010 @ 12:40PM

IRS Torture By Mail

Do you fear being grilled by an Eliot Ness-wannabe from the Internal Revenue Service? Unless you have a secret offshore account, are running a cash business mostly off the books or are earning millions a year, that shouldn’t be a worry. If you’re a reasonably law-abiding taxpayer, fear instead the IRS’ computers and its vague letters demanding more cash.

In 2008 IRS agents and examiners audited only 310,000 individual taxpayers–one in 450–in person. But lower-paid, lesser-trained IRS employees, working largely off computer data, performed 1.1 million “correspondence audits,” sent out 3.2 million “math error notices” and mailed another 3.5 million “CP-2000″ letters stating that taxpayers seemed to have left some bit of income off their returns.

Since 2000 the IRS has tripled the number of correspondence audits. In her 2009 annual report National Taxpayer Advocate Nina E. Olson pegged them as one of the most serious problems facing taxpayers. Now, with the IRS widening its use of “math error” notices, too, she’ll be adding those to her 2010 list of taxpayer horrors, she tells us.

While they may sound innocuous, the math notices are sometimes more vexing than the correspondence audits. In a correspondence audit, the IRS zeroes in on an issue or two that stand out on a 1040–say, big deductions for charity or unreimbursed employee business expenses–and sends a letter asking the taxpayer to produce documents supporting those deductions within 30 days. According to the Treasury’s auditors, mail-handling problems at the IRS sometimes mean taxpayer responses don’t get to the right person in time. But in theory, at least, the taxpayer has a chance to make his case.

Likewise with a CP-2000 notice–based on a mismatch between the taxpayer’s return and the W-2s and 1099s sent by employers, banks and brokers to the IRS–the taxpayer is told what he supposedly omitted and given 30 days to explain. In some cases you can call the IRS and point out where the income was included on your 1040. If, that is, you don’t mind holding–the IRS’ “service goal” during this tax season is to answer 71% of calls and only after an average taxpayer wait of 12 minutes.

But with math error notices, the IRS skips a step: It adjusts the tax owed before asking the taxpayer to explain. The current math notice doesn’t even disclose that a taxpayer has 60 days to ask for an “abatement,” although Jodi Patterson, director of the IRS’ Office of Taxpayer Correspondence, promises that a new notice form due out this summer will mention it. “Eventually, we’ll get to all of those notices that are still a disaster,” she says.

Asking for an abatement forces the IRS to have a human examine the issue. Otherwise, the tax is automatically assessed and a taxpayer is left with no choice but to wrestle with the IRS’ collectors or go to court. “You can really harm taxpayers if you don’t apply it [the math error procedure] right,” Olson observes.

If a taxpayer made a simple math error, where’s the harm? With most tax returns now done on computers, arithmetic errors are rare. But Congress has granted IRS authority to issue summary math adjustments for 16 types of errors, including the catchall one of “incorrect use or selection of information” on a tax schedule or form. “That’s a Pandora’s box,” complains Bryan Gates, an enrolled agent in Belleair, Fla., who had a client denied all his hurricane losses with a math notice. The IRS is using the math error procedure to deny the new $8,000 first-time homebuyer credit and the $800-per-couple Making Work Pay credit, as well as the earned income tax credit.

Just as bad as the preemptory nature of math error notices is their vagueness, says Rick E. Oelerich, an enrolled agent in Davenport, Iowa, who teaches classes for other tax pros on how to read the notices. Get this: The notice includes a nine-digit number, which represents up to three separate three-digit coded explanations of the adjustments. Taxpayers can go online for an explanation of the codes, but even then could have trouble pinpointing where the mistake supposedly occurred. Example: Code 227 means there was an “error in the computation of Alternative Minimum Tax” but doesn’t let on where on the 55-step amt form the error was. (While the new IRS letter will say what line on the 1040 has a mistake, it still won’t say where the problem is on the amt form.)

Just as the definition of math errors is expanding, so, too, is the list of items the IRS audits by mail. These now include Schedule C, which sole proprietors use to report business income and expenses, and Schedule E, for investment real estate. Olson argues this is bad for the tax system. Why? A by-mail audit can nix inadequately documented (even if legitimate) business deductions but isn’t likely to detect unreported income. The net effect, she worries, is to tick off reasonably compliant folks while emboldening the true tax cheats.

So what should you do to avoid IRS grief? First make sure every 1099 you get is accounted for on your return. If it’s wrong, try to get the issuer to fix it; if you can’t, attach an explanation to your 1040, advises San Francisco tax lawyer Robert W. Wood, who writes a column for Forbes.com. Save every receipt for charitable deductions and business expenses–even small ones. Paper, not common sense, is king in the by-mail audit world.

If you get an IRS letter, open it, read it and deal with it immediately, no matter how vague or off-base it might seem. Don’t expect that initial letter to come by certified mail, even if big dollars are at stake. “Bad things happen to people who ignore IRS correspondence,” says Olson.

Beanna Whitlock, a San Antonio tax preparer and former IRS employee, is now helping a 50-year-old executive who overlooked (or, as he tells it, never got) an audit notice that gave him 30 days to substantiate $41,000 in charitable deductions. He saw the IRS’ second letter; it assessed $17,000 in back taxes and penalties but didn’t indicate there was an earlier letter he hadn’t responded to. The deductions were all legit, and the man has the documents to back them up, Whitlock says. But in trying to clean up the mess, she says, she’s had to deal with IRS telephone representatives who don’t know what the amt is and with IRS fax machines that constantly return a busy signal because they’ve run out of paper. “It’s becoming increasingly difficult for American taxpayers to deal with this agency,” she complains.

So you rush to open your IRS mail and then what? If it’s a by-mail audit or a lot of money is at stake, get professional help. If it’s a CP-2000 letter or a “math error” notice and you prepared your own return, first try to isolate the discrepancy. Maybe you did really put some item on the wrong line. If you had a pro prepare your return, he or she should be ready to take a look at the letter for no charge and to fix it for free–if he or she caused the error. But if it’s the IRS’ mistake, or yours, expect to pay for the help.

The IRS won’t say what minimum discrepancy generates a CP-2000 letter, but Oelerich says he’s seen demands for as little as $25 in added tax. Tax pros say many taxpayers are so loath to tangle with the IRS that they pay up, even if they believe they don’t owe the money. If the amount is small enough, that’s not necessarily a bad choice–depending on what your time is worth or what a tax pro might bill for hanging on hold.